Yuan plunge opens up risk of margin call-style losses

Since the People’s Bank of China doubled the trading range of the yuan to 2 per cent higher or lower than the daily fix on Monday, the currency has been allowed to slide further.
Photo: Bloomberg

by
Vesna Poljak

Foreign exchange markets are scrambling to make sense of the impact of a falling Chinese yuan on complex investments that risk falling out of the money and defaulting if the newly widened currency depreciates further.

Since the People’s Bank of China doubled the trading range of the yuan to 2 per cent above or below the daily fix on Monday, the currency has been allowed to slide further.

The US dollar jumped to 6.218 yuan on Thursday, its highest level in a year, taking this week’s losses in the Chinese currency to nearly 1 per cent and putting pressure on bets that depend on an appreciating yuan.

China’s currency has been on a remarkable winning streak for almost 10 years, in spite of its peg and most strategists have a long position in offshore-traded yuan as one of their main calls this year.

But the PBOC seemingly has another agenda in the short term. It deliberately devalued the yuan last month ahead of the widening of the trading band to reintroduce the concept of two-way ­volatility. Part of that motivation is to deter speculators out of yuan by forcing losses. The squeeze on these opaque trades is akin to a margin call in that downward foreign exchange movements could require investors who have borrowed cheaply in United States dollars and deployed their capital in high-yielding Chinese investments to incur losses, stump up greater collateral or potentially face default.

Shake out speculators

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“If the Chinese currency is weakening and people that have put these structures in place are having to service these US dollar loans, out of either CNY (offshore) or CNH (onshore) which is weakening against the US dollar, it’s costing them more to do that," Mr Attrill explained.

“The currency losses wipe out the losses that you’re making on the higher interest rate. There’s a lot of interest in that at the moment so there’s the potential for a bigger spike higher, therefore weaker Chinese currency."

More significant is the policy intentions behind the PBOC’s currency strategy. Experts tend to agree that it wants to shake out the speculators from the market but it needs to find a balance that does not bring about widespread casualties. Mr Attrill hypothesised that the goal was “teaching speculators a lesson and convincing them there are two-way risks in the currency but not to the point of triggering a wave of defaults". “The lesson to some extent has already been learned."

An analysis by Morgan Stanley suggested the intervention was by design “to realign the exchange rate and deter speculators". “This may pave the way into more reform measures, including widening the daily trading band of the CNY-USD in the near future," said its strategists and economists in a report.

NAB still sees a higher offshore-traded yuan in the long-term.

Its forecasts are for 5.95 yuan to the US dollar by the end of 2014; 5.80 yuan to the US dollar by the end of 2015; or 5 CNY to the Australian dollar by the end of 2014 and 4.64 yuan to the Australian dollar by the end of 2015. The Australian dollar is currently fetching about 5.59 yuan.